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CIAO DATE: 8/01
A Prescription for the Economy
On The Issues
June 2001
Who is to blame for the weakening U.S. economy? The current energy shock could push the country into a short-term recession, but only policy blunders would likely be able to prevent a quick recovery.
The 50-basis-point reduction in the federal funds rate on May 15 marked the fifth rate cut by the Federal Reserve this year. This key interest rate is now 2.5 percentage points below where it was in early January. These aggressive and timely moves have been motivated by reports of considerable weakness in the economy, reports that seemed to have turned more negative in the spring.
Indeed, despite the Fed actions, many observers still think the United States will enter a recession. John H. Makin, my colleague at the American Enterprise Institute, has gone one step further, arguing that there is a strong chance that the United States is about to enter a prolonged depression: "History . . . offers little consolation to those claiming that depression is not inevitable after an investment-led boom that ends with a stock market collapse. In the United States after 1929 and in Japan after 1990, the only two instances in this century in which stock market collapses followed investment booms, depression resulted" (AEI Economic Outlook, April 2001, "A Primer on Depressions").
Our knowledge of the economy is limited, and a quick recovery could just as easily happen. But if we do enter a prolonged period of economic decline, people will be looking for someone to blame.
One candidate is the Federal Reserve, which last year used illusions of an inflationary "wealth effect"—high equity values leading to excessive consumption—to justify rate hikes that, in retrospect, were clearly in error. The Left, naturally, is trotting out another candidate: President Bush.
But history suggests that recessions aren't necessarily the result of domestic-policy errors. Since 1945, the U.S. economy has experienced ten recessions. In normal times, gross national product advances, on average, a bit more than 3 percent per year. During a recession, it contracts by about 0.5 percent per year and layoffs become widespread. The one blessing is that recessions have typically been very short in modern history, with the average recession since 1945 lasting only eleven months.
And what kicks the economy into recession? Economist James Hamilton of the University of California at San Diego has demonstrated in a number of important papers that oil shocks are often to blame. In 1956, war in Egypt shut the Suez Canal to oil tankers. Oil producers cut production by 1.7 million barrels a day in November, roughly a 10 percent decrease in world oil production. Prices surged, and in August 1957 we were formally in a recession.
In 1973 an Arab oil embargo helped drive the economy into recession. The 1980 Iran-Iraq war caused world oil production to drop 7.2 percent. By July 1981 there was a recession. Iraq invaded Kuwait in 1990, and our last recession occurred at the same time.
Now another massive energy shock has again pushed us to the brink of a recession. Sure, there have been other factors. The surplus everyone is talking about means the government is taking too much money out of the productive economy. Federal Reserve policy was too tight last year. But those forces have been present in the past through good times. No, if we enter a recession, the oil shock coincidence is too striking to ignore.
Another Negative Shock?
So the lion's share of the blame clearly does not belong to Mr. Bush or Mr. Greenspan. This will be small consolation to Republicans if they are run out of town in next year's elections because of a soft economy. But those elections are still eighteen months away, and if we have a recession that lasts that long, there will be plenty of blame to go around.
Recessions are usually short because our free-market economy is so resilient. If oil prices stay very high, we will trade our gas-guzzling sport-utility vehicles in for Honda Civics and use the money left over to purchase new running shoes. While there are winners and losers, the economy as a whole will keep chugging along. There is no reason to believe that the adjustment will be longer this time—unless we are hit by some other negative shock.
A quick survey of the landscape suggests that there are two policy candidates for that role: a return to Fed tightening and a wimpy tax cut.
Although the Federal Reserve has once again quite artfully responded to changing economic conditions, it is unusual and disturbing that the stock market has not celebrated. (The May 15 cut barely budged the main stock indexes.) Why not? While it may partly reflect a lack of faith in the power of interest-rate policy, it is also likely that Wall Street is concerned that the Fed has yet to publicly concede past errors and may even be poised to repeat them.
Most ominously, the Fed has explicitly justified recent interest rate reductions (including the 50-basis-point cut on May 15) by pointing to the lower stock market. This raises the specter that the Fed will rapidly raise interest rates if the economy and the stock market begin to recover.
About a year ago, I wrote in the Wall Street Journal that the wealth effect is likely not inflationary because consumption responses to higher wealth are not rapid, but capital spending responses are. In theory, the resulting higher capacity could even put downward pressure on prices.
At the time, gross domestic product was growing at an annual rate of 5.6 percent, consumption was growing 3.1 percent, and investment was increasing at the astonishing rate of 21.7 percent. Over the past twelve months, the Dow Jones Total Market Index has declined about 17.5 percent. In response, investment spending dropped 11.5 percent in the first quarter of 2001 (our most up-to-date measure) and consumption increased 3.1 percent, exactly the same rate as a year ago. Inflation? It went up. This is not the pattern one would expect to see if the Fed's wealth-effect analysis were accurate.
Add to that record the observation that economists universally agree that last year's wealth-effect-motivated rate hike was a mistake, and one would hope to see the Fed backing off of the stock-market rhetoric. If it does not, expect continued weakness.
The Role of Policymakers
The second possible policy error is a smaller-than-expected marginal tax-rate reduction. The president's plan has likely been built into market expectations. Incredibly, "moderate" Republicans appear poised to water down Mr. Bush's tax plan considerably. If they succeed, then this negative surprise will likely depress markets and prolong the downturn.
Such a scenario is hardly unprecedented. Economists Christina and David Romer recently wrote an exhaustive study of the history of fiscal and monetary policy. They found that fiscal measures generally have failed to push the economy out of recession because they have been too small to have much of an effect. Indeed, large fiscal stimulus packages have generally not been passed near cyclical troughs. Instead, they have historically emerged only because of slow recoveries, as was the case with the 1964 tax cut.
In other words, if we are talking about a stimulative tax cut next year at this time, our elected officials will have repeated past errors. The cut passed this year will have been too small.
With history as a guide, then, it is safe to say that no policymaker can fairly be blamed for our current circumstances. If the economy is still soft a year from now, however, that will no longer be true.
Kevin A. Hassett is a resident scholar at AEI. A previous version of this article appeared in the Wall Street Journal on May 16, 2001.
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